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About 90% of VIC members have probably just hit next already, some may have even shorted a few shares on their way to another idea (66% of the float is already short). You are probably wondering; why should I even think about a five dollar stock with $37 a share in debt? Won’t video on demand (VOD) kill these guys? Aren’t they the ones who outbid the most incompetent management on the planet (Blockbuster) to takeover a company twice their size using debt right before the industry imploded? Therein lies what I call opportunity; when no one will even considering reading about a company who’s shares are down more than 80% in six months and where most of the float is short, you probably have an overlooked company. The question is if this stock is overlooked for a very obvious reason, or is there some potential hiding out just under the surface.

Let me start this idea out by stating that the shares are clearly mis-valued. They are not worth $5. They are either worth $0, or many times the current quote. I’ll be honest and say that there is a decent chance (maybe 30%) that these shares will be at $0 in the very near future, but with a 70% chance that they go up 3 to 5—fold; I’ll call this a very educated speculation with good odds and leave it at that. Longer term, this is a very troubled industry: but it may take a number of years for that to happen and in the interim, these guys may be able to earn a few dollars a share for a number of years into the future if things play out like I anticipate (or hope…).

For those of you who are unfamiliar with the industry, Blockbuster is the gorilla that dominates the home video rental industry by sheer size (not competence). When number 2 player Hollywood Video (HLYW) came on the market early in 2005, #3 player Movie Gallery (MOVI) got into a bidding war and succeed in grossly overpaying to acquire a company twice its size, thus becoming the number 2 player with a over a billion dollars of junk rated debt.

We can all look at stock charts and press releases to see that since the acquisition, the industry has melted. However, I want to draw your attention to the pro-forma financials for the combined entity for 2004’s fiscal year end as if the two had been together since the start of the year, (found in the 8-K/A filed on 7/11/2005 starting on page F-65). These numbers include a number of adjustments along with a rather significant interest expense increase ($54 million) related to the debt the company incurred doing the acquisition. What people fail to notice is that in 2004, this combined company earned $82.5m or $2.59 a share based on the 31.9 million shares currently outstanding. This includes $84.5m ($2.65shr) in interest expense, 10.5m in reclassification expenses to make both statements conform, and between $5m and $10m in acquisition expenses and deferred financing costs which are lumped into both SG&A and interest. I can’t seem to break them out, but it is likely that true earnings were in the neighborhood of $3.00/shr in 2004.

During the first quarter of 2005, the pro-forma combined entity earned $1.13/shr. The adjustments here are even harder to break out, but I think it is safe to say that acquisition costs were even higher during this quarter. In any case, nine months ago, this combined entity was capable of earning over a dollar a share in one quarter and around three dollars a share for the full year. During the two most recent announced quarters, this company lost a good deal of money. We all know about the ‘headwinds’ that this industry faces, however, I simply refuse to believe that these have metastasized over the past nine months to such an extent that this business is now incapable of earning a profit—especially since many of these factors have existed in some form for years now (NFLX, VOD, piracy, internet downloads of the legal nature, etc.) There have to be other forces at play which have destroyed Q2 and Q3 earnings. I will return to the more obvious ‘headwinds’ later and comment on the briefly.

The business has a relatively fixed cost structure; it is the incremental video rental revenue on this fixed store base that is responsible for most of the operating income and operating leverage. The first thing to look is same store sales. These have been abysmal. Both MOVI and BBI blame a terrible release schedule. Even the most ardent bear must accept this factor. There are two things to keep in mind when looking at box office revenue, rental revenues and ultimately SSS. Firstly, this isn’t a physics equation and they do not track exactly. For instance Napoleon Dynamite did poorly in theatres, only to do spectacularly in the rental market. Secondly, the release date is when the rentals start. For good comps, you need a number of quality releases in succession. Similarly, a poor release schedule will take a while to work its way through the system. To show just how terrible the release schedule was, in Q2/2004, 35 titles with over $50m in box office revenue were released and the average box office revenue for the 58 movies over $20m was $89.5m. This compares with 30 titles over $50m released in Q2/2005 and an average box office take of $73.6m for all 57 movies over $20m. While the numbers improved in Q3, there is a few month amortization period for the bad titles to ‘run off’ and enough of the good titles to be on the shelves before comps improve. Q2 doomed Q3. Q3 also had to contend with The Passion Of The Christ which was an incredibly popular rental title in 2004. I think we are back to a more normalize release schedule and comps have improved markedly in the past six weeks as I’ll explain at the end.

During the last two quarters, the company has also had a number of operational snafus. I think that people forget that MOVI’s acquisition of HLYW was a hostile take over. MOVI was not even allowed on HLYW property until the deal closed. Then the next day, all sales began to be attributed to the combined entity. MOVI did not have time to look at HLYW and figure out how to implement the merging of the two separate entities. This created a massive headache for MOVI management, especially because HLYW management seems to have burnt a few bridges on the way out. Friendly mergers are often difficult, this one was large and declining metrics in the short term are only to be expected.

Firstly, while they’ll deny it, MOVI management lost some focus on existing operations as they were overwhelmed with merging the two entities. We cannot quantify this impact—except to say that management admitted having to scramble and implement many changes ahead of plan because of the sudden drop off in comps. Secondly, new MOVI stores have been built progressively smaller over the past two years as the company does not need to allocate 40% of the store space to VHS. This has reduced the average store size by between 1000-2500 square feet. HLYW has not made this adjustment (probably because they intended to sell the company anyway and were focused on good numbers in the short term). The average HLYW store was slightly larger to begin with and this means that the newly acquired stores are often 2000 feet too large. This has naturally impacted revenue per foot and led to excess rent. This problem is slowly being rectified as the company is slowly subleasing space and returning excess footage to landlords—however this is a slow process and may take at least a year to show much impact. Once complete, I believe there will be a major reduction in rental expense looking out two to three years (especially because most leases are only five years to begin with and will be reworked upon renewal).

Additionally, in their haste to eliminate redundant positions, they fired the guy responsible for allocating regional interest movies to HLYW stores. We talked to a number of stores that complained that they were in very Hispanic neighborhoods and could have rented out hundreds of copies of certain foreign/Hispanic interest films (Carlito’s Way came up a lot in conversations), but instead received only two copies (even though they asked for a few ‘walls,’ whatever that means). I think this is part of the burnt bridges feel left over from former management where HLYW employees are afraid to speak up while the company is still eliminating ‘redundant’ positions. Once again, this is an issue that is not quantifiable, but probably cost them a few million in rental revenue over the past six months—yet is slowly being improved upon. Let’s say that this cost HLYW a mere of 1% of revenue, or about $3m a quarter, this would lead to $2m less gross margin, almost all of which drops to the bottom line. This could easily have cost the company almost a nickel a share each quarter in after-tax income alone.

Finally, MOVI forced their point of sale system onto HLYW. This created a monster issue for HLYW stores as the software and hardware didn’t mesh well and led to many computer crashes. MOVI also did not spend suitable time training the HLYW staff. Don’t forget that they are working mainly with high school students here. At an existing store, when someone is new and doesn’t understand the software, they ask another employee. When no one at the store knows what’s happening, they call tech help. For the past nine months, MOVI usually had two tech help guys on duty at a time and they have been absolutely inundated with calls. From talking with HLYW staff, the wait time is usually 2-3 hours. This means that if the first sale at 7 pm fails, it won’t be until 10pm before they can ring up another customer (peak hours are most of sales, so a whole day is lost). Naturally, rentals have suffered. I talked to management about this and they are moving to fix the problem by hiring more tech support. They didn’t realize there had been a problem because, once again, no one has complained about it. Furthermore, the roll out of the MOVI software has been staggered, so they didn’t see the sales drop off at the headquarters level because there are only a few dozen stores at a time flailing around. I cannot quantify this, but from speaking with dozens of stores and maybe 100 employees, it’s safe to assume that during the 1-3 week software integration period at each store, that store did about a third less revenue. Call it a guestimate at best, but this probably hit comps for at least a few hundred basis points overall at HLYW stores over the last two quarters. Were this responsible for just 300 bp of negative same store sales, that would be almost $6m of gross margin ($.13/shr) each quarter in missed after-tax income. Luckily, the software roll-out is nearly complete, so even if management was merely playing lip-service to my observations, it should not be much of a factor going forward into 2006.

Finally, while the company reported $39m in pretax losses during Q2 and Q3, $30.5m of these losses were integration expenses and non-cash expenses related to conforming HLYW’s accounting to MOVI’s. Despite what the headlines may wish you to believe, the company only lost $8.5m in the two worst quarters in 5 years for rental releases, despite rather significant integration hassles as MOVI swallowed a company twice its size. The company did this while also spending on new store expansions which did not generate revenue and a handful of investment banking fees related to the completed acquisition. If it could survive the ‘perfect storm’ and only lose a quarter of the $35.3m (after-tax) they made in Q1, maybe the bear case isn’t that coherent. If you include the tax benefits realized in Q2 and Q3, the company didn’t even lose money after the charges, but made a few dollars. These benefits are really a reduction in the tax expense from Q1.

So, how will 2006 look? I’ve got to tell you that I cannot even hazard a guess. I don’t think that anyone can, but the company made around $3 in 2004. I’ll admit that the ‘headwinds’ will likely impact SSS, but who knows how much. For the moment, let’s say that VOD and NFLX do not even exist. They made $ 133.3m in pro-forma, pre-tax income in 2004. Since then, they have taken on more debt and also had their interest rate increased. However, the company was expecting $40m in pretax synergies. Let’s say they get about half that number—which will essentially wash with the added interest expense. Let’s say they had $5m in due diligence costs for the acquisition and financing in 2004. They also had $10.5 in one-time adjustments to change the accounting method from HLYW’s to MOVI’s. If you add this to the $133.3m number, you get about $148.8m in pretax income and using a 38.2% tax rate (rate used in the pro-forma), you get to around $92m in income or $2.86 a share. This also includes various growth initiatives that will slow down significantly going forward. Using round numbers, let’s just call it $3.00 a share in 2004 income.

Here is where it gets real interesting. The company is currently paying $24.4m a quarter run rate ($97.6m for the year in interest). Interestingly, today the bonds closed at 77.77 or a yield of 16.836. There are a lot of very accretive things that the company can do with any cash flow to buy back this very high cost debt and reduce the interest expense considerably. (Every dollar spent will reduce debt by $1.30 and reduce annual interest expense by almost $.17). I am curious if they are already doing this, but we’ll have to wait until Q4’s financials which come out in the spring. I think that the company has been very unfairly treated by the banks over the past year. The banks have cued off of BBI’s disappointments and have made financing more expensive than it should be. Should MOVI’s results for the next few quarters improve, I expect much more generous terms from the banks, which could cut the current interest expense down by 30-50% between a pay down of principal, reductions in interest and retirement of the highest yielding bonds, either at the discount that exists in the current bond market, or through a redemption in the future. It isn’t too hard to conceive of market conditions returning to roughly 2004’s level, the pay-down of some debt along with better interest rates, maybe a few additional synergies from the acquisition along with subleasing some stores and arriving at an earnings per share number as high as $4 within 2 years. Of course, as long as they stay solvent, I think this is at least a double—just on short covering. As I said before, I really have no idea what they’ll make, but I’d say there’s a 70% chance that they’ll make between $.75 and $3.00 next year and between $1.00 and $5.00 in 2007. There is of course the 30% chance that by this time next year MOVI is the bank’s problem, but based on how quickly the banks were willing to let BBI off the hook, I don’t think they’ll close it down unless things really implode.

Of course, people will wonder where this cash flow is coming from if the company intends to expand. I really do not think they intend to expand. They have already entered into leases on the 150 new stores for 2006. It is prohibitively expensive to back out of these leases, especially because a reasonable chunk of the total build-out cost has already been spent. Beyond that, I doubt expansion will be a focus until some debt is paid down. However, this is a business which has historically had very high returns on capital—were the business not in decline, this may be a good use of capital. Let me also state that if they stop growing, maintenance cap-ex for the store base (excluding rental inventory stock) will be around $30m less than depreciation (or almost a dollar a share of higher FCF than the income statement). This should significantly help in paying down debt.

With two thirds of the float short, clearly the bears must see something wrong with this rosy situation. On 12/31/2005, uva687 wrote up the bear case. I was wondering if the bears would uncover fraud or anything really egregious. Instead, it was just what I’ll freely admit. The company is grossly overleveraged and facing a number of very large technological ‘headwinds’ over the next few years. I’d be remiss to not mention these. I recommend you read uva687’s write-up as well. I will address his points one by one in bullet point format.

Classic Value Trap—Cannot argue here. This is a declining business. However I have always been taught that a stock is worth the present value of future income. These guys are profitable and a moderate uptick in the business will show just how much scale these guys have over a fixed cost structure—especially after spending six months cutting excess expense. With the market cap at around 15% of the enterprise value, a moderate increase in EV will more than double the shares (with so many shorts, even a downtick in business may rally the shares). I am a bull—yet I don’t think the business will exist in the same form in 10 years. However, I think peddling entertainment is a good business and these guys will survive in some format—especially given the brand name, scale and great real estate. Looking over the past 4 years (2001-2004), revenue per store is up every year, and EBIT/Store has actually increased slightly since 2001 (though 2004 saw a slight dip). Are those the signs of a value trap or a growing business that has experienced a hiccup?

Debt Covenants—Even if they blow through the covenants, the banks do not want to take a bloodbath on $800m in debt. Can you name me a banker who wants to run a movie rental chain? They’ll amend the covenants again—especially if they are getting a very juicy interest rate already. We saw this with BBI a few months back, MOVI is in better financial shape and I am not even convinced that they will violate any covenants.

Most bear cases are either based on them blowing the debt covenants or the more long term view that the business is going to disappear as different methods of content distribution take hold. As a crowded short, you’d better be prepared to take a lot of pain as you wait this out. Even if right, it may take a few years to happen.

Think of it this way. NFLX has been around for years now. I would guess that they’ve taken about as much business as they will. NFLX is great for getting an obscure foreign movie that a chain location will not have. I think NFLX has already harmed the business significantly. However, there is a time lag involved when you order from NFLX. I’ve polled everyone I know—most are like me, they get a movie on the way home from dinner or work. It is an impulse thing based on store location more than anything else. Most NFLX aficionados still use video rental stores frequently.

VOD should have all the selection and the time availability problems solved. I think this is the case and most business erosion will come from VOD going forward, however rental chains have a certain window where they have sole distribution. As long as they are willing to pay to buy the DVD, the movie studios will continue to give them priority. I’d even argue that if MOVI got into real trouble, the movie studios would fix the payable terms or help refinance MOVI’s debt or just about anything else to keep MOVI going. They need MOVI as much as MOVI needs them. MOVI accounts for $2.1 billion in revenue. No one wants to see that disappear.

Now, I know that most people will wait a month for this window to close, every quarter it gets a day shorter anyway. This isn’t a massive barrier really. Hasn’t a certain portion of this happened already? In this case, MOVI is lucky, about half their stores are out of major metropolitan markets. I think the cable companies are in dire straights and cannot roll out VOD without significant new capital expenditures. I think that they will find the cost of capital to be prohibitive for this. MOVI will experience some pain in the major markets however.

Finally, this brings us to the internet and outright internet piracy. I think piracy is the biggest threat—but the studios have the content and are increasingly being more careful about how they let this out into the wide open. For example, new HDDVD technology from Sony/Toshiba has built in anti-copy protection. Will the studios compete directly by letting people download a 48 hour rental that disappears from the hard- drive after? Why earn $3-$5 for one rental, when they can get $15 by selling the product to MOVI? How many renters want to wait 30 minutes for the two hour movie to download and then try figuring out how to put it on their TV? Most movies are watched by groups of people. How many people can crowd around a 3 inch i-pod screen to watch a movie? That’s a stupid question—they’ll go to MOVI and get the DVD for their new flat screen TV.

That is not the best answer, but here is the most logical one. My mom does not use NFLX, cannot pirate movies and can barely check her email. Her i-pod is still in its cellophane rapper. She is a frequent movie renter and will likely always be a renter. She didn’t even get a DVD player until this summer!! In the end, these stores will need to align their cost structures to a lower revenue stream from a very core base of loyal consumers. I think that after 5+ years of infringement on the video rental business, what is left is a core consumer base that spent over $2.1 billion dollars last year at MOVI/HLYW alone. I think that given time, the company can continue to shrink into a smaller cost structure. One very variable cost is number of new videos purchased. If the company buys less, the utilization of each video increases and the gross margin percent on each video goes up. Unfortunately, this is less net margin on an otherwise fixed store base. However, during Q2/Q3, had the company ordered 10% less videos in anticipation of this slump, they would have shown a very significant profit. The extent of this slump was unprecedented, and caught them by surprise. My point is that given time, the company can continue to cut costs to some extent.

There are strong indications that the slump experienced over the last two quarters has finally ended. Early in Q4, comps continued to be down in the high single digits, but since better movies have come out, comps have been consistently positive over the past six weeks. In fact, industry comps as reported by videobusiness.com were up 17.7% over last year for the most recent week (ending 12/25/2005).

Finally, BBI has really stumbled with this no late fee policy. It has led to people not returning videos and the company does not have the financial capacity to increase their working capital sufficiently to buy more rental stock. I repeatedly hear from friends that BBI never has anything they want in stock and they are going to other stores instead. As the number 2 player, MOVI must be gaining some market share. CEO Malugen is no Antioco. He has successfully built a business up from a handful of stores to the number two player over twenty years. He has overseen dozens of acquisitions and knows what steps need to be taken to cut costs and integrate the two companies. He’s not here to feed off the company like Antioco does at BBI. His salary is not completely unreasonable and with 4.6m shares (14.7% of total). I think his interests are clearly to increase (restore) shareholder value. Unfortunately, short term stumbles have lumped MOVI in with the never-ending disaster called Blockbuster when viewed by the market.

Management guided Q4 to have comps that were down 5-9%. Based on recent trends over the past few weeks, I would not be surprised to find out that comps came in roughly flat, or maybe even up a tad for the quarter. This momentum should carry through to Q1, especially when the new Xbox games finally hit the shelves and help out the video game rental segment. This incidentally concurs with what we repeatedly hear when calling the stores. They tell us that this is their best holiday season in a number of years. This doesn’t sound like a company where competing technologies have stolen the revenue. Maybe it really was just a bad product release schedule, coinciding with a fall off in video game rentals because of new platforms.

Continued in message section.

Catalyst

Good Q4
Short Squeeze
BBI having to retrench. When there are 2 stores in a zip code, they split the rental business. When one goes under, the other gets the excess revenue applied to a very fixed cost structure and EBIT/Store explodes.